What is activity-based costing?

You may have heard of activity-based costing (or ABC), and here I will try to explain the basics of ABC. First, just a short reminder of the types of cost an organisation may have.

Costs are often classified as fixed or variable. Variable costs change in line with volume/output, and are often called direct costs as they can be attributed easily to a product or service. Fixed costs, often called indirect costs, do not change when business output changes. For example, a fixed cost might be rent of a premises or the salary of a general manager. Such costs cannot be easily traced to a product or service. However, if no effort is made to trace fixed costs to products or services, then the business does not know the full cost. This makes decision-making more difficult.

Traditionally fixed production costs are absorbed into a product by means of a rate per labour hour. For example if overhead was planned at €1 million for a year and 100,000 labour hours were to be worked, then each labour hour would mean a €10 overhead cost. So a product taking two labour hours to make would be charged €20 overhead.

The traditional method can be criticised as over the years more and more overhead has been non-production type overhead and not related to the number of labour hours spent making a product – indeed automation of production in many industries has seen labour being of decreasing importance.

Another more modern way to allocate overhead to products is using ABC. The key in ABC is the word “activity”. In ABC, we can think of an activity as a collection of tasks which are linked in terms of being an overhead cost. For example, customer service, facilities management, quality control and machine setup are all examples of activities. The resources of the activity are determined, which are used to determine the cost of the activity – typically for a year. Then, what causes these resources to increase or decrease is determined. This is called a cost driver. For example, more complaints from customers will increase the resources needed by a customer service department. Using the cost driver, the overhead cost driver rate can be determined. Here’s a brief example:

A design department costs €100,ooo per annum – costs such as salaries, design materials, computer running costs etc. The more designs for new products the greater the cost, this designs are the cost driver. Lets assume there are 5,00o designs per annum, thus the cost driver rate is €20 per design. A product which needs say three designs will thus incur a €60 overhead costs for designs using ABC. If a product has nor designs, then zero overhead is incurred.

In a business, design (as per the above example) may just be one cost driver. Thus, the more resources (activities) consumer by a product the higher the overhead cost. This seems to make a lot of sense, and thus ABC is often used where overhead costs are not easily traced using direct labour hours (or similar) as a means to allocate overhead cost.

With ABC, all direct costs are assigned to the product/service in the same way as traditional costing methods. It is just the allocation of overheads that differs. Typically, ABC considers not only production overhead costs, but many other overhead costs which can be defined within activities.

2 responses to “What is activity-based costing?”

When I think “types of costs,” I generally break them down into direct, indirect and sustaining costs and consciously build those three distinctions into my model’s activities as cost attributes. From my experience, this helps the ABC practitioner better align the types of tasks (i.e., activities) a company performs with their corporate cost structure in terms even the “financially-challenged” can understand. The fixed vs. variable distinction is a gray area for some, and the lines between either are often blurred by the contractual arrangements (e.g., outsourcing, fixed price, etc.) behind the cost. Here’s how I think of things…

Does the cost in question directly touch the good or service and is it necessary for production? Is this something concrete a customer would be willing to pay for? If so, then you have a direct cost. Indirect costs are associated with those activities that are one-removed from the product. Think of the warehouse that provides a part to be used in making some “thing” or the engineers’ drawing specifications for a finished product. While a customer might understand these costs as necessary, would they be unwilling to purchase them directly? And lastly, think of sustaining costs as those organizational activities (HR, C-suite, financial reporting, etc.) that most call overhead. While you definitely must re-capture these costs through smart product pricing, a customer would never willing pay for these upfront.

By defining the activity as either direct, indirect, or sustaining and associating costs based on the type of activity performed, it provides a clear alignment between action and cost – the very heart of activity-based costing.